While the concept did not appear in my recent economics worked solutions, the relevant chapter in the textbook talks about the paradox of value – one of the earliest conundrums that economists grappled with.
It is often posed as the paradox of water and diamonds. Why is essential, life-giving water cheap, while useless but pretty diamonds are so expensive? Here’s Adam Smith:
Nothing is more useful than water: but it will purchase scarce any thing; scarce any thing can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.
It is rather puzzling. After all, a man lost in a desert would trade every diamond in existence for a few bottles of water.
It was ultimately explained using the concept of marginal utility. It is the utility gained from the last quantity of water or diamonds that gives it its value. And as I have explained before, you get less utility from each additional unit you get – that’s the law of diminishing marginal utility.
The first gulps of water make the difference between life and death – you gain a huge amount of utility from it and would fork out a lot of money for it. Then water can be used to provide basic hygiene and sanitation – again very, if not quite as, important. Eventually, you might end up buying a bottle for the gym, or to water the potted plants – not all that useful, and so not worth all that much. The last water you buy isn’t that valuable, so water is cheap.
As for diamonds, the first one shows what a big-shot you are – a Master of the Universe soaring high above the common throng – it’s an incredibly valuable form of conspicuous consumption. The second – well, not many get onto their second. And that’s the point. The last diamond you are likely to buy is that immensely valuable one that shows you’ve made it. The last diamond you buy is hugely valuable, so diamonds are expensive. That’s a brief overview of the theory. I’ll look a bit further into it in the next post.